Credit Linked Notes

Certain investors are prevented from entering into derivatives contracts, either by law or by internal investment policies. Credit Linked Notes (CLNs) allow such investors to derive some of the benefits of credit derivatives.

Credit Linked Notes (CLNs) are regular debt obligations with an embedded credit derivative. They can be issued either directly by a corporation or bank or by highly rated special purpose vehicles created by dealers. The coupon payments made by a CLN effectively transfer the cash flow of a credit derivatives contract to individual investors.

Credit Linked Notes are best understood by a simple example: ABC Investments would like to take on the risk associated with the debt of XYZ Corp., but all of XYZ’s debt is composed of bank loans and ABC Investments cannot simply sell protection in a Credit Default Swap (CDS) because its investment policy prevents it from entering into a derivatives contract. Let us assume that the size of ABC Investments desired exposure to XYZ Corp. is $100 million. One way of gaining the desired exposure to XYZ’s debt is for ABC Investments to purchase $100 million in Credit Linked Notes that reference XYZ Corp. The issuer of the notes may take ABC Investments’ $100 million and buy highly-rated debt obligations to serve as collateral for its CLN liability towards ABC Investments. At the same time, the CLN issuer enters into a credit default swap with a third party, selling protection against a default by XYZ Corp. From that point on, the CLN issuer will simply pass through the cash flows associated with the credit default swap to ABC investments. In the event of default by XYZ Corp., the CLN issuer will pay its default swap counterparty and the Credit Linked Note terminates with ABC Investments receiving only the recovery value of XYZ’s defaulted debt. If no default occurs, ABC Investments will continue to receive the coupon payments associated with the Credit Linked Note until its maturity date, at which point it will also receive its principal back. It should then be clear that a credit linked note is simply a funded way of entering into a credit derivatives contract.

Source: Report of the working group on introduction of credit derivatives in India.

Uses of Credit Linked Notes

1. Credit Linked Notes allow the cash flows of derivatives to be “repackaged” into securities that can be bought and sold in the market place. This is especially useful for some classes of institutional investors like mutual funds.
2. Investors who do not have master credit derivatives agreements with dealers are attracted to credit linked notes as they generally require less documentation and lower set up costs than outright derivatives contracts. They can also be tailored to meet specific needs of investors.
3. They can help increase the liquidity of certain otherwise illiquid assets. For instance, CLNs that reference a pool of bank loans can be trade in open market without restrictions, whereas actual sales of loans might be subject to restrictions and approval by the borrowers.
4. Bankers/ dealers too find value in the issuance of CLNs as they provide dealers with an additional vehicle to hedge their exposures in other credit derivatives positions.

Source: Credit Derivatives-Research Report